We have previously dubbed Shannon McConaghy’s Horseman Global the world’s most bearish hedge fund for one reason: as recently as a few months ago the fun had taken its net equity short position to an unprecedented -100%. At the end of September, it had modestly trimmed this short to a more modest -87.5%

What is perhaps just as impressive is that despite the fund’s massive bearish bias, if only in equities, it has managed to keep its YTD return virtually flat, with more profitable than unprofitable months so far in 2016. The offset? A whopping 66% gross long position in bonds.

And while we have recently documented Horseman‘s pessimistic outlook on Japan, when it comes to the most bearish hedge fund in the world there are shorts, and then there are shorts. In its latest, October, letter to clients the fund reveals what it believes may be just one example of the latter, having taken its exposure in the sector to a massive -20%, and what – if true – could be the next “big short” idea.

This is what Russell Clark, CIO of Horseman, said in its latest letter to clients:

You fund made 1.44% net this month, with gains from the short book and the currency book offset by losses from bonds.

“I know he is a good general, but is he lucky?” is apparently a quote from Napoleon. I often think about this quote when looking at the investment management industry. There are numerous successful fund managers who I have looked at and met, who I would describe as more lucky than good. There are far more fund managers I have met who I would describe as good, but unlucky. In fact, the market will almost by definition create more unlucky managers than lucky managers, as almost all jobs in fund management tended to be created at market tops.

This is quite well known, and it is why most investors are always try to invest where no one else is, in some bombed out sector that lacks excitement. While I understand this, it has two very major problems. Firstly, how can you be sure it’s totally bombed out? As my first boss pointed out to me, the difference between a stock that has fallen 80% and a stock that has fallen 90% is 50%. Secondly, liquidity at lows can mean you will not be able to exit for many years.

From my point of view, why don’t we try and do the opposite? Pick out sectors that have been fashionable with managers that have been in the right place at the right time, and then short sell what they own. It has two big benefits. First I find timing this to be much easier. And second, at the top of the market liquidity is plentiful. The only issue is you have to be able and willing to short sell.

So how do you pick a sector or strategy that is at the top of the cycle? Perhaps the best sign of all is a fund that has grown assets rapidly. In the US, I find funds that have reached 20bn in AUM from 5bn in AUM within one or two years are typically great places to look. I feel that when a fund manager grows that quickly, they are typically focusing on maximising management fees over performance.

So what funds have we been looking at recently. As detailed in my recent note on Japan based US REIT funds, these funds look particularly egregious to me. Furthermore, they are raising assets even though US REITs in Yen terms have gone nowhere in the last few years. I find this an exciting area to short, and we have taken this sector to 20% of the fund this month. I find there are a number of equity income funds that have also grown rapidly over the last few years, and I am looking carefully at their long positions for short ideas.

My other observations about fund management has been that investors are pulling out of active strategies and buying passive strategies. There are good reasons for this, as the unpredictable shifts in momentum in the markets have caused active fund management to underperform significantly. However, it feels to me that passive strategies have grown too fast too quickly. I think active fund management is about to have its day in the sun.

Given that the Horseman Global fund is short equities and long bonds, that is about as active as you can get. Or in other words, I am getting bullish on bearishness!

Clark then gives the following drilldown on the US REITs sold in Japan to justify his bearish stance:

This month profits came from the short portfolio, in particular from the European and Japanese banks, automobile and consumer staples sectors.The long portfolio incurred a modest loss.

In Japan one perk of getting old is a gift of a silver cup from the prime minister in the year you celebrate your 100th birthday. As the Japanese population is aging, almost 32,000 people were eligible to receive the gift this year, up 4.5% from last year, the government decided to present cups made of silver plate rather than sterling, this year, reducing total spending on the gifts.

The birth rate in Japan has been low for many years (1.4 per woman versus 1.9 in the US and the UK) and the country has very little immigration. As a result the population is ageing. According to the estimate by the Internal Affairs and Communications Ministry, the ratio of people 80 or older accounts for 7.9 percent of the total population, which is more than the entire population of Sweden. The National Institute of Population and Social Security Research forecasts that people aged 65 or older will account for 36.1 percent of the total by 2040. For more information on Japan’s depopulation please refer to Shannon McConaghy’s notes entitled ‘South West Japan Trip’. In our opinion depopulation is a major deflationary force as it suppresses domestic demand.

The generation of 21-year-olds entering the workforce is the first to have grown up in a broad state of deflation. Since their birth year in the 1995 residential land prices have fallen 47% including a fall over the last year. With the ratio of abandoned houses expected to rise from 16% to 28% by 2033 it is likely that land prices will continue to fall. With real estate making up 23% of the core consumer price index it is hard to see sustained inflation.

Deflation has also suppressed wage growth, with average monthly earnings falling 8% from Yen 315,000 in 1996 to Yen 289,000 in 2015, the most recent August data shows another decline in average monthly earnings YoY. In turn, tumbling expectations of future security have fuelled savings. A student from Tokyo recently interviewed by the FT said “I often surprise myself. I am more conservative than my grandmother, she lived in a time of war.” Another student said: “Deflation lives in our minds and has become normal. I am sure that if you gave me Y100,000 now, I would save 99 per cent of it.”

The Bank of Japan adopted ‘Quantitative Easing’ some 15 years ago. The resulting low domestic interest rates, have fuelled the ‘Carry Trade’, a strategy in which a Japanese investors seek foreign denominated assets that offer higher yields than domestic assets. But ‘Carry Trades’ are inherently unsustainable as they are founded on the belief that currency rates over time will not adjust back to reflect relative inflation and interest rate differentials. Examples include Japan’s overseas investments into Australian dollar assets before the Global Financial Crises which swiftly lost money as the currencies corrected.

US-Reits sold in Japan have seen large inflows from Japanese investors recently as they offer ~25% yields. In our opinion they are riskier than generally perceived, please refer to Russell Clark’s note entitled ‘Japanese US REIT funds and the buy case for Yen’ and ‘Japanese US REIT Fund – an update’. We expect Japanese fund flows into US REITS to reverse at some point. Over the past few weeks we have built a 17% short position in US REITS. We remain positive on the Japanese Yen relative to the US dollar as carry trades collapse.

While Horseman is clearly bearish on Japan, however, its biggest net short exposure remains in the US, where it has a nearly -40% net position.

Finally, while hardly known for its longs, here is the breakdown of the fund’s Top 10 long positions.